The five-year private equity itch

BY Praveen Chakravarty

A display of lack of trust through investor agreements is a wrong starting point and possibly a signal that the company does not merit investment in the first place.

There are 1,341 companies in which 120 private equity funds have invested close to $51 billion more than five years ago. As private equity investments in companies approach the five-year milestone, investors start to squirm about exits and collecting a return on their investments. Unfortunately for these private equity investors, an exit has proved to be elusive, thus depressing their return ratios substantially and even leading to the shutdown of some funds and possibly threatening the future of this very important asset class in India. Is this merely a case of a marriage between private equity investors and their portfolio companies gone awry or was there a fundamental mismatch right from the start?

Ask a private equity investor for the firm’s investment process and a typical response is, “We back credible, trustworthy management teams with who we share a strong chemistry, that have the vision to spot large market opportunities and possess deep execution skills to build successful businesses. We think of ourselves as partners to entrepreneurs and add tremendous value through our vast network and experience”.

An investment decision supposedly made on this premise of trust and credibility with the entrepreneur, seems to lose this character in the investor agreement between the entrepreneur and the investor and acquires a strong flavour of distrust and need to protect oneself at all costs.

A typical private equity investment agreement (term sheet) issued by a private equity investor to an entrepreneur and a simplified interpretation of it read like this.

1: Preference shares: Our shares will carry preference over yours. Yes, we are your ‘partners’ in building this business, but we will be treated preferentially.

2: Preferential accumulated dividend – Our shares will carry a 9% dividend from the day we invest. Even if the company doesn’t have enough profits yet to pay dividends, it can keep accruing. We will collect all of our accumulated dividends first as soon as the company is profitable enough before the entrepreneur who built the business can claim any dividend.

4: Guaranteed return of 25% - We will need a guaranteed return of 25% on our investment. Yes, it’s not a loan or uncollateralised debt but since we are taking a ‘risk’ on you, our special form of equity will get a guaranteed return. If the business doesn’t perform well, we are entitled to our guaranteed returns as bank loans but if it does very well, then we will be entitled to our share of profits, unlike a bank loan.

5: Put option – After five years, we have the right to force you to buy our shares at a price that will give us that guaranteed 25% return. Even if the company doesn’t have the money to buy back our shares, you can mortgage your house, family Jewellery or do whatever it takes to buy us out and give our money back.

6: Drag along/Tag along/Veto rights – If after five years, we change our minds, we can force you to sell your company to anyone at any price. On the other hand, if you want to sell the company or your shares to anyone, we have the choice to either veto it or tag along with you.

7: 3x liquidation preference – Should the company shut down, we will have the first right to take out three times our money from the liquidation proceeds of the company before you get a penny.

8: Board rights/Right to appoint CFO – Since we don’t trust you to not run away with our money nor do we think you can run your business efficiently on your own, we will appoint a disproportionate number of board members, a new CFO and new auditors. However, despite this, if the company still fails, we are entitled to our guaranteed returns and other protections.

Steve Jobs is famously supposed to have told his design team about consumers, “Don’t listen to what they say; watch what they do”. This aptly sums up the subtle tension that permeates entrepreneurs and private equity investors in India.

The investment terms that most private equity firms have adopted in India are a replica of 21st century American private equity investment terms that many first generation Indian businesses are being forced to fit into. Maybe herein lies the most important lesson in private equity investing in India—this display of lack of trust through these investor agreements is perhaps a wrong starting point and possibly a signal that the company does not merit investment in the first place.

Private equity is pivotal to India’s private enterprise-led growth model that can catalyse job creation by private businesses unlike China’s government-led development model. Hence it is critical that this asset class succeeds in India and conceivably by staying true to higher risk-higher reward nature of equity, perhaps the mutual trust between businesses and investors can be restored and the asset class can flourish.

(The author is the CEO of an investment bank and a successful angel investor. Views expressed here are his own.)

Comments

A candid article Pravin. The situation is indeed piquant. In good companies, where funds fall over each other for the deal, a lot of the above can be negotiated (however even here some funds have a malpractice of renegotiating terms on SHA after a lot of time/money has been spent on DD). For average but investable companies, funds tend to over protect themselves by protecting themselves in all scenarios. Another big dent on PE image is the practice of many funds to unnecessarily engage management time when they have little intention to invest (maybe to just get some gyan on the sector/ company).
The general rant one hears from managements is that PE fund raising process is a big waste of time. And on top of all this, new issues have come in last few quarters - funds approving an investment but their LP's declining the investment or significantly changing the terms. I am dreading that day, when a promoter comes back and says that he would like to discuss the term-sheet with the LP's and not with the fund manager...

I think this article paints a very distorted picture of a typical PE term sheet.
Investment in the form of preference shares is common, particularly for early stage businesses or those where valuation is very high. It essentially means that PE investors will get their money back first ( sometimes with accumulated dividend) if the company does not do well and still manages to find a buyer.
Guaranteed return is not very common. If the company does not do well, where will the promoter find the money to honour this commitment, even if it is in the term sheet.
The put option is almost never in the form stated.
Drag along is typically subject to a number of caveats, including lack of other exit option within say 5 years, ROFR for promoter to buy or find other investor to buy at offer price etc.
Unlike PE in USA, the investor has a minority stake. So it is reasonable to ask for special rights/veto rights on certain matters- typically raising fresh capital, acquisition/divestment of a part of the business, capex budget etc.
On appointing top management, PE concurrence is required typically when new positions are to be filled. No PE fund will invest in a company and then say they want to change the CEO/CFO/CXO. The fund LPs will ask a lot of questions about such a move.
The fund investment decisions are always taken by an investment committee, on which the management of the PE advisory firm is a minority. Sometimes - not often- advisors recommendations are not accepted by the investment committee.
It is easy to portray PE funds as the bad guys. The term sheet described can only be signed by promoter who looks at valuation in isolation, and is being advised by a banker who is looking only at his success fee.

I think it's a bit of a chicken & egg. Is it the combination of some shady promoters plus lack of enough exits that's given rise to these 'onerous' terms, or do these onerous terms create an environment of distrust that mitigates against successful growth/exits. The answer lies somewhere in between. In any event, regardless of what the SHA says, enforcing these provisions in India is difficult to say the least, and any savvy promoter knows that. Perhaps this is why they don't mind signing up for these ostensibly draconian terms and investors get a false sense of comfort. The Indian legal system also needs to take some of the blame - the average time to liquidate/wind up a company in India is 10 years, which is the average fund life!.

With all due respect.....I disagree with most of this article! The author has cleverly employed rhetoric to make a seemingly compelling set of arguments. But since I think this article paints an unhealthily imbalanced picture of PE/VC investors, and an inaccurate canvas of a "typical PE term sheet", I would like to make the following point-by-point response to this article.
1. Firstly, I disagree that the keenness of an investor to "protect oneself at all costs" amounts to starting the relationship off on a note of distrust. Absolutely not. The purpose of agreements is clarity, and clarity is required even between two totally trusting partners with wonderful chemistry. And if that document goes all out to "protect oneself at all costs", what's particularly wrong in that?
2. Preference Shares - Yes, we are partners. And yes, my shares will carry a preference over yours. Because we are NOT equal partners - you are the stronger partner who controls this company, and I am the minority partner. I am the guy who's paying you a valuation premium to fund YOUR company's growth, and I need my shares to have preference over yours so that I don't lose my money in a downside scenario. Hardly unreasonable, I'd say.
3. Preferential cumulated dividend - Dividend is permitted to be paid only out of profits. The rationale behind cumulating dividends is that an investor should not lose a "preferential dividend" that he has been promised when he invested on account of unprofitable years that the company may have. While one can debate whether a PE/VC investor should get a preferential dividend or not, in my experience, I have very seldom seen anything close to a 9% preferential dividend rate being suggested by the author. My experience has more been an infinitesimal rate of dividend, primarily to comply with a company law technicality.
4. Voting Rights - In my experience, voting rights clauses usually merely say that the investor will get voting rights on what is known as "as-converted basis". All this means is that though they are holding preference shares (which don't carry statutory voting rights), the investor will get voting rights assuming that his entire holding is in equity shares. I have never seen investors getting disproportionately higher voting rights than promoters, other than in very rare "Material Breach" type situations.
5. Guaranteed Return of x% - Well, the way I see it, guaranteed returns discussions usually stem from huge mismatch of expectations between promoters and investors on valuation. An investor may well say, for example, "I can only give you this valuation if all your projections are achieved and if they are, then that tantamounts to giving me a x% return on my investment. We think you wont achieve the numbers that justify your valuation number, but we will go with your belief if you back it up with an IRR guarantee." So......the point am making here is: it is not be accurate to portray a "guaranteed IRR clause" merely as "investors' risk aversion".......it is just a valuation discussion taking shape in a manner and form acceptable to both the promoters and investors.
6. Drag-along rights - "If after five years, we change our minds, we can force you to sell your company to anyone at any price."......not quite! "Change our minds" on what exactly? It's more like......if we can't get a credible liquidity event (which is in YOUR control as management) even after 5 years of investing in your company, we need to find the best buyer with the best price for our shares, and that will often mean that you will have to be forced to sell too. After FIVE Years! And besides, the "at any price" bit should hardly be a concern for promoters.......it is very unlikely that an exit price that is attractive to a PE/VC shareholder (who has paid a much higher price than the promoters!) will be unfair to the promoters (of course, it could be "perceptionally unfair", but not in basic economic terms).
7. 3x Liquidation Preference - I have never seen this in my experience....it has usually been 1x. I have seen 2x in very rare cases. I agree that a high liquidation preference right is very onerous and unfair but I don't believe such rights are "typical" in PE/VC term sheets. I could be wrong, though.
Lastly, some disclosure - I don't work in a PE/VC firm :-) I represent and advise companies as much as I do PE/VC investors. This post is not driven by any desire to pick up cudgels for the funds, but only to present what I consider to be a balanced picture.

Vijay, by providing a long, point by point response in legalese, you have fallen right into the trap of Chakravarty's larger point that he's making in his article. a well drafted, detailed pre-nup is perhaps a sign that its a wrong marriage to get into in the first place is the analogy. private equity investment is inherently about investing in an entrepreneur. downside protection through complicated term sheets is not a solution but can actually exacerbate the mistrust

Thanks for your comment, Gautam. I certainly hope I haven't "fallen right into the trap" as you have suggested :-) I think the author (and I guess you too, because of the pre-nup analogy you have cited) are assuming here that an entrepreneur doesn't really want to have a detailed agreement in investment deals, and only the PE/VC investor does. Not at all the case, in my experience representing entrepreneurs - a promoter is as anxious as an investor is to have a clearly drafted, watertight document that "protects him at all costs" - and am saying, there is nothing wrong or unreasonable in that. It is just good business sense to have a document that leaves both parties clear on where they stand in various situations - and what goes into that document is a matter of negotiation.

Vijay, thanks for the detailed response. There is no question of any trap here, it is just a healthy discussion. It is important to know the details of both sides of the story. And I thank the author too.